Steve Carrigan, Mortgage planner and Branch Manager of Pinnacle Financial in Camarillo, CA wrote a great article which presents the history of the mortgage lending industry in the United States, what is happening in this industry today, and how the changes affect/benefit the consumer. It is reprinted here with permission. I hope you find this interesting!
Saga of the US Mortgage Industry
The Old System of Mortgage Lending
By Steve Carrigan
Once upon a time, during the good old days when life wasn't so complicated, banks lent money to borrowers and never sold these mortgages to unfeeling, multi-billion dollar institutions with call centers in distant lands.
Anyone could walk into his or her local bank and get a local home loan without signing truckloads of paperwork and being interrogated as though they were America's most wanted criminal. There was no fraud or borrower manipulation. There were no reckless bank failures or irresponsible lending practices. In those days, bankers were compassionate, foreclosures were minimal and consumers were respected. RIGHT?
Wrong. Selective memory is a wonderful thing...
Mortgage lending in America used to be a simple affair. Deposits were made to banks, and banks in turn used the deposits to fund loans. However, this simple and rudimentary system of banking did have some HUGE drawbacks.
Remember the old Jimmy Stewart film, It's a Wonderful Life? In that film, Jimmy Stewart plays a small town Savings and Loan banker named George Bailey. George was the good guy. His nemesis was Mr. Potter, the big bad monopolistic banker who would have controlled the town, renamed it Pottersville and kept the commoners dirt poor had George Bailey not been around to stop him.
During the film, which was set during the 1930s and 40s, George the good guy almost lost the family bank during the many "bank runs" that occurred. A bank run is when most, if not all, of the people who have deposited money in a bank decide to withdraw their money all at the same time. This panic-driven event is caused because bank customers get scared that the bank will fail and they will lose the deposits that they have at the bank. Well, needless to say, this often becomes a self-fulfilling prophesy because if everyone pulls their money from the bank all at the same time, the bank WILL fail!
You see, the way banks make money is by paying the depositors a small interest rate on their deposits and then lending that same money to borrowers at a higher interest rate. In essence, the bank is borrowing money from you, the depositor, and lending those borrowed funds to your neighbor, the borrower who applies for a mortgage. Then, the bank borrows money from your neighbor when they deposit their money, and the bank loans those borrowed funds to you when you apply for a mortgage. That is how banks operated under the old banking system.
As you can imagine, this system, while simple and easy to understand, had many flaws:
- Numerous banks failed frequently during the many bank panics that occurred in this county throughout the 1800s as well as the 1900s. It was very easy for depositors to get anxious and withdraw all their money from the bank whenever a piece of bad news hit the town or local economy.
- It was very easy for the "Mr. Potters" of the world to take advantage of ordinary Americans because these "Mr. Potter" robber-barons had the deep pockets to snap up the failed banks at bargain basement prices. In this scenario, rampant fraud and unfair business practices were the norm due to easy manipulation of the banking system. The rich got richer while the poor got poorer.
- To protect themselves from failing in the scenario illustrated above, banks only issued mortgages that were "callable." In other words, the banks had the right to call up every one of their borrowers and "call the loan due" immediately and for any reason. If you didn't have the money to pay back the bank, you lost your home, not because you couldn't make the monthly payments, but because the bank couldn't meet the panic-driven withdrawal demands of the depositors.
Needless to say, this archaic system of mortgage lending allowed only very limited mortgage choices, and the lending guidelines were dreadfully restrictive.
The new system of mortgage lending
As time when on, and after the economic recovery that began during World War II, the US government and financial markets began exploring new ways for Americans to buy homes in ways where we wouldn't be at the mercy of a small clique of wealthy bankers. Thus, the "secondary mortgage market" system was born.
In this new system, bankers would be empowered to take all the mortgages that they issued to various borrowers and sell those mortgages to other investors in an "after-market." In other words, if you owe the bank money, the bank has a valuable asset-your IOU! Two things happen when the bank takes that asset and sells it to someone else:
- They hope they can make a profit
- They can replace the funds that they loaned to you and loan more money to someone else
This process of loaning money and selling those mortgages to other investors is what we call mortgage banking.
In this sense, the banking process of taking a deposit from you as the bank depositor is separated from the banking process of loaning you money as the bank borrower. You are the same customer, but the bank sets up two different departments to service your needs. One department handles your checking and saving accounts, and the other department handles your loans.
In this sense, one hand no longer has to be involved with what the other hands is doing.
The new system really has three steps with some action taking place on the sidelines:
- Step 1 - Consumers get loans from mortgage banks or brokers
- Step 2 - The mortgage banks or brokers sell that mortgage to secondary market investors like Fannie Mae, Freddie Mac and other financial institutions
- Step 3 - Secondary market investors package these mortgages as "securities" or bonds. This process is called "securitizing" the mortgages into a financial product that can be sold to Wall Street investors like mutual fund companies, individual investors and others.
On the Sidelines: Warehouse lenders provide the interim financing for the mortgage banks. In other words, if a mortgage bank isn't taking in deposits from banking customers, where do they get the money to loan out in the first place? Well, another group of lenders fill in the gap and loan money to mortgage banks during this interim period. These lenders "warehouse" these loans for short periods from one to 60 days, while the mortgage banks sell them to Secondary market investors.
How does this new system of mortgage banking benefit the consumer?
The money for your mortgage is coming directly from Wall Street sources. This basically means that you have, literally, hundreds of millions of investors across the planet who are itching to lend you mortgage money by investing in the mortgage bonds that trade in the US financial markets.
The result?
- You have an unlimited amount of cash flow and financing options because mortgage companies have financial incentives to innovate and create new mortgage products. The more products they create and sell, the more money they make and the more choices you have. As the saying goes, "when banks compete, you win."
- There is less room for manipulation and abuse due to competitive market pressures. If can't get what you want now, just go down the street and chances are, someone else is offering it better, cheaper and quicker.
- There are consumer protections, flexible and fair lending guidelines that protect minorities and ensure that all Americans have access to mortgages and can buy their own homes.
The bottom line here is that in the US, we have a uniquely American, full-blown democratic process of getting a mortgage and buying a home. No other country in the world has this system. That is why we have literally thousands of mortgage choices that cater to just about any need you could possibly think of. Whether you are caring for elderly relatives, sending kids to college, trying to retire comfortably, investing in real estate, buying a second home, getting a divorce, starting a new family, or starting a business, there are mortgage options for you.
Does this system have flaws. Yes, absolutely. In any highly democratic system, there is a need for discipline.
If you let people do anything they want without rules, chances are someone is going to get hurt sooner or later. That is exactly what has happened recently in the mortgage industry.
You see, Wall Street investors were all looking for very high returns in the financial markets. So, they basically told the mortgage bankers, "Create new products and we will buy them." The mortgage bankers joyously replied, "Sounds great to me!" And so were born all the "no credit, no income, no problem!" loans. Consumers got greedy for loans they couldn't afford, mortgage banks got reckless in their guidelines and Wall Street investors in search of high returns, financed the whole she-bang.
When loans began going sour earlier this year, Wall Street investors decided to pull the plug and stop buying the risky mortgages from the banks. In fact, they even started requiring the mortgage banks to buy back all the loans they had sold them in the first place! In other words, the system started working in reverse - instead of providing new money to the mortgage banks, Wall Street started sucking money back from the banks. To compound the problem, the "Warehouse Lenders" who were providing interim financing from the sidelines created a "run on the mortgage banks" by closing down their lines of credit and calling all their loans due.
So there you have it! Instead of a consumer-driven run on the banks, we have a Wall Street and Warehouse Lender-driven run on the banks! This liquidity crunch is currently affecting the entire mortgage industry. Mortgage banks who were very profitable up until this very moment are going out of business. They aren't going out of business because they are no longer profitable. They are going out of business because of the "liquidity crunch" caused by this "run on the banks" phenomena just described.
Warehouse lenders are shutting off the interim financing spigots and wall Street investors are reversing the flow of money by asking mortgage lenders to buy back loans they sold them in the first place. The financial institutions with big cash reserves are sitting on the sidelines waiting to snap up all these failed mortgage banks at bargain basement prices - just like Mr. Potter was waiting for George Bailey to come crawling to him for helps.
What Is the Answer and What Can Be Done About the Situation?
That is the million dollar question! We know that we can't go back to having a small group of wealthy bankers in smoke-filled rooms limiting our financing options for us. We also know that this fully democratic US mortgage process isn't 100% foolproof either. Here are some solutions that should be implemented immediately:
· FNMA & Freddie Mac need to be given increased loan limits in order for them to purchase larger loan amounts from lenders in the high cost states. Their current loan limit of $417,000 means that any mortgage above this amount must be either held by a lender in portfolio or sold to Wall Street in the form of an ABS (Asset Based Security) where there is currently no market.
· Minimum requirements for loan terms for those with blemished credit. Had the sub-prime loans had a minimum period of at least five years before any change occurred would have given these borrowers a fighting chance at improving their credit in order to shift to a standard mortgage.
· Require that all borrowers being given sub-prime loan terms are required to receive independent counseling that would ensure that they understood their options and responsibilities when it comes to the largest loan of their lifetime.
· Stronger standards for loan officers to require that the borrower's interest is being looked after. Many of the sub-prime borrowers where given sub-prime loan terms when they could have easily qualified for standard terms. The loan officer made the decision based on compensation rather that the best loan terms for their borrower. Standards of prudence such as those applied to the financial planning field should be adopted.
· Prohibit builders and realtors from acting as a lender when involved in the sales process. A buyer of a home should be given home purchase advice that is separate from mortgage finance advice. This would eliminate the possibility that the builder or realtor might pressure a buyer to make an unsound financial decision in order to facilitate a sale.
Steve Carrigan is a Mortgage Planner and is Branch Manager of Pinnacle Financial in Camarillo. He has been a financial advisor in Southern California for more than 25 years. His professional designations include Certified Mortgage Planning Specialist, Preferred CalHFA Lender (for First-Time Home Buyers and School Employees), Preferred CalPERS Lender, and Certified Liability Advisor. On behalf of the Area Housing Authority of the County of Ventura, he provides free education on homeownership topics each month throughout the county. He also heads the Housing Task Force Committee for the Camarillo Chamber of Commerce. To send Steve a question, visit http://www.askstevecarrigan.com/; you may also call Steve directly at 805 389-0282
Comments(1)